FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 5A
YTM, Yield Curve and Credit
Spread

FINA 3080 Prof. Chao Ying 1

 Review of Lecture 4
• What if you do not have enough Money?
– Buying on Margin: borrow money
– Short Sale: borrow financial assets

• All no-default bonds are portfolios of Zeros

T = maturity
Coupon Par Value
Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T

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 Lecture 5A Outline
• Yield to Maturity
• Measuring the returns for a bond investor
• Bond prices over time

• Interpreting the yield curve: provide information

about the future economy
• Default risk, ratings and bond yields

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 Yield to Maturity (YTM)
• YTM: internal rate of return (IRR) on a bond
– The discount rate that solves the pricing equation

• YTM is quoted as a bond-equivalent yield

T = maturity
Coupon Par Value
Bond Price = ∑ +
t =1 (
1 + YTMBEY
2
) (
t
1+ YTMBEY
2
)T

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 Yield to Maturity Example
20
35 1000
950 = ∑ +
(1+ r )
T
t =1 (1+ r )
t

10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate r = 3.8635%
YTM = 2*r.

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 Yield to Call
• YTM: assume the bond will be held until maturity

• Callable bond: may retire prior to the maturity date

– If interest rate falls, the bond price rises

– Callable debt allows the issuer to repurchase the bond

at the call price.

– Yield to Call

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 Bond Prices: Callable and Straight bond

• Straight (noncallable) bond: 30Y + 8% + $1000 par

• Callable bond: callable at 110% of par value ($1100)
• High r: the risk of call is small since p<<1100;
• Low r: the risk of call is high since p is close to 1100.

FINA 3080 Prof. Chao Ying

 Other Yields
• Bond Equivalent Yield: semiannual rate x 2

• Effective Annual Yield: (1+semiannual rate)^2-1

• Current yield: Annual coupon payment/current price

• Realized compound yield (RCY):

– Return on a bond with all coupons reinvested

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 Realized compound yield vs. YTM
• 2-year bond; par =$1000
• Annual 10% coupon payment
• YTM=10%, P0 =$1000
• Hold till maturity

P0*(1+RCY)2= V2

In A, V2 =$1210, RCY=10%

In B, V2 =$1208, RCY=9.91%

RCY=YTM when reinvestment rate = YTM.

FINA 3080 Prof. Chao Ying
 Holding Period Return
• HPR: Realized compound yield over holdings
periods greater than one period.

• The forecast of total return depends on both

1. Forecast of YTM when you sell the bond
2. Forecast of reinvestment coupon income

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 HPR: Reinvestment and Resale

Year 0 Year 20 Year 30

10
(1+6%)20−1 75 1000
75 ∗ =2,758.92 966.45 = � +
6% (1 + 8%)𝑡𝑡 (1 + 8%)10
𝑡𝑡=1

FINA 3080 Prof. Chao Ying

 Comparison of Yields and Returns
• YTM equals the realized compound yield when
– Reinvestment rate equals YTM
– Bond is held to maturity or YTM at sale is equal to
YTM at purchase

• When does holding period return differ from

YTM?
– Change of YTM & sell before maturity
– Reinvestment rate not equal YTM

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 Bond Prices over Time
T = maturity
Coupon Par Value
Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T

• With constant interest rates, present value of

1. Par payment increases exponentially
2. Remaining coupon payments decreases exponentially
• Two effects exactly offset when the market interest rate equals
the coupon rate: issue at par.
• Premium bond: sell above par (r<coupon rate); 2nd dominates
• Discount bond: sell below par (r>coupon rate); 1st dominates

FINA 3080 Prof. Chao Ying

 Overview of Term Structure
• Term structure of interest rates: relationship
between YTM and maturity.

• The yield curve is a graph that displays the term

structure of interest rate

• Information on expected future interest rates

can be implied from yield curve.

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 Treasury Yield Curves

• Rising yield curves are most commonly observed.

• Why 4 different patterns: Expectations Theory and Liquidity Theory

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 Expectations Theory

• Definition: YTM is only determined by expectations of

future short-term interest rates.
• Example. Current 1-year interest rate: 8%
• Next Year: investors expect it will rise to 10%

• Two-year bonds offer yields 8.995%: upward sloping

• If next year’s interest rate < 8%: downward sloping

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 Forward rates
• Forward rate: the second-year interest rate that makes
the following two strategies equal:
1. Hold the 2-year bond directly
2. Buy 1Y bond; roll the proceeds into another 1-Year

1.089952 = 1.08 ∗ (1 + 𝑓𝑓2 )

Which implies the forward rate is 𝑓𝑓2 = 10%.
• Extend to equating the return on year n:
(1 + yn)n = (1 + yn-1)n-1(1 + fn)

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 Example of Forward Rates
• 3-year YTM y3=7%; 2-year YTM y2=6%
• Two equivalent 3-year strategies
• Buy a 3-year zero
• or buy a 2 year zero and roll over into 1 year
zero at year 2 at forward short rate f3
• (1+y3)3=(1+y2)2 * (1+f3) f3=9.02%
•(1+yn)n=(1+ym)m * (1+f)n-m ; where 𝑛𝑛 > 𝑚𝑚

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 Liquidity Theory
• Investors will demand a premium for the risk
associated with long-term bonds
• Short-term bonds have more liquidity:
– Less price uncertainty
– Trade more frequently with lower bid-ask spread
• Liquidity premium: compensate to long-term
– spread between forward rate and expected short rate
• The yield curve has an upward bias even when
rates are expected to remain unchanged!
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 Why Would the Curve Slope Up?
• Investors expect short rates to rise in the future
– Economic growth (demand for capital is rising)
– Inflation is getting out of control
• Real rates will go up; and/or inflation will rise
• Investors prefer short-term bonds (and
borrowers don’t) even
• Marginal investor is a “speculator” (or needs cash now)
• Firms have long-term projects with delayed payoffs

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 Treasury Yield Curves

• The combinations of both Expectations Theory and Liquidity Theory

• Inverted yield implies falling interest rates: indicates a coming recession.

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 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 5B
Interest Rate Sensitivity

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 Lecture 5B Overview
• Bond Pricing Relationships
T = maturity
Coupon Par Value
Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T

• Find Zero prices at different interest rates

• Define a general measure of rate sensitivity
– Illustrate the features of duration
– Duration, modified duration, and price change
– Convexity
– Rules of duration
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 Zero Prices at Different Rates
• Consider a Zero maturing in year T
• Use the bond pricing equation to get the price
– PV of $1,000 par payment: Price = $1,000 / (1 + y)T
• If interest rates are 0%, then price = $1,000
• If rates go up to 2%, then price depends on T
∆𝑝𝑝
– When T is 3 years, price is roughly $940, 𝑝𝑝
= −6%
∆𝑝𝑝
– When T is 5 years, price is roughly $900, 𝑝𝑝
= −10%
– Larger maturity has larger price sensitivity

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 The General Rate Rule for Zero Prices
• Denote the price by P
– P = Par / (1 + y)T= Par * (1 + y)-T
– dP = -T*Par * (1 + y)-T-1 *d(1+y)
– dP = -T*P * (1 + y)-1 *d(1+y) = -T*P *d(1+y)/(1 + y)
– dP/P = -T*dy/(1 + y)
– %(Price chg) = -Maturity * %(Discount rate chg)
• Price sensitivity for Zero is captured by maturity
(go back to the previous slide)
• We can use the Zero rule to obtain a general rule
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 Rate Sensitivity of a Portfolio of Zeros
• Replicate: coupon bond is a portfolio of Zeros
– Portfolio weights depend on the bond’s cash flows

• Portfolio sensitivity to rates

– Weighted average of the sensitivity of the Zeros

• Coupon bond duration= Portfolio sensitivity

• Use the bond duration to estimate price changes

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 Bond Duration Formula
• Duration D: effective maturity of bonds
– The weighted average of the times until each
payment is received
• The weights wt proportional to the present value
of the payment.
T
CFt /(1 + y ) t
D = ∑ t × wt wt =
t =1 Bond Price
• Duration is shorter than maturity for all bonds
except zero coupon bonds.
– Duration is equal to maturity for Zeros.
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Cash Flows Paid by 9% Coupon, Annual Payment Bond
with an 8-Year Maturity and 10% YTM

T
CFt /(1 + y ) t
wt = D = ∑ t × wt
Bond Price t =1

Year 1 2 3 4 5 6 7 8
Pay
PV Bond price
weight
Duration Total Duration

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Cash Flows Paid by 9% Coupon, Annual Payment Bond
with an 8-Year Maturity and 10% YTM

T
CFt /(1 + y ) t
wt = D = ∑ t × wt
Bond Price t =1

Year 1 2 3 4 5 6 7 8
Pay 90 90 90 90 90 90 90 1090
PV 81.82 74.38 67.62 61.47 55.88 50.80 46.18 508.49 946.65
weight 0.09 0.08 0.07 0.06 0.06 0.05 0.05 0.54
Duration 0.09 0.16 0.21 0.26 0.30 0.32 0.34 4.30 5.97

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 Duration/Price Relationship
• Price change is proportional to duration and not to maturity.
∆ P/P = -D x [∆(1+y) / (1+y)]
• Modified duration describes a percentage change in bond price
with respect to the yield change
D* = modified duration = D / (1+y)
∆ P/P = - D* x ∆ y

• Duration rule underestimates the bond price b/c of convexity

– Recall that derivatives are only local approximations
– The rule works best for small changes in rates
– Larger interest rate change will generate larger error

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 Visualizing Convexity
Price

Pricing Error from

Convexity

Duration

Yield

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 Convexity: Estimated and Actual Price change
𝑇𝑇=𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Bond Price = �
(1 + 𝑦𝑦)𝑡𝑡
+
(1 + 𝑦𝑦)𝑇𝑇 ∆ P/P = - D* x ∆ y
𝑡𝑡=1

A
∆P
B
P Δy>0
-D*

-D*
Δy<0 C

Δy
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 Bond Convexity
• Relationship between bond prices and yields is not linear

• Rate sensitivity (duration) changes with YTM

– Convexity captures this idea (if linear, duration is constant)

• Convexity is important for large rate changes

• Bonds generally have positive convexity

– Preferred by investors: An increase in a bond’s YTM results in
a smaller price decline than the gain associated with a decrease
– Duration rule underestimates the bond price
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 Bond Duration in Practice
𝑇𝑇=𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Bond Price = �
(1 + 𝑦𝑦)𝑡𝑡
+
(1 + 𝑦𝑦)𝑇𝑇
∆ P/P = - D* x ∆ y
𝑡𝑡=1

• Example of annual coupon bond:

– 2-year 10% bond with initial YTM of 10%
– Price = $1,000 initially
– Duration is 1.909 years
• Modified duration is 1.909/1.1=1.735 years
– If rates go up to 11%, then price falls to $982.87
– Estimated price with duration is $983.08: error=22c
– Where 982.65=1000-1000*1.735*1%.
– If rates fall to 9%, then price goes up to $1,017.59s
– Estimated price with duration is $1017.35: error=24c
– Here YTM only change 1%. Higher Error if higher change.
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 Summary of Duration
• Three key interpretations

– Definition: interest rate sensitivity of a bond

– Weighted average of time until cash flows received

– Tool for measuring and eliminating interest risk

(next slide)

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 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 5C
Duration and Immunization

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 Lecture 5C Overview
• Passive bond management: immunization
• Discuss portfolio immunization
– Immunization of interest rate risk
– (modified) duration of assets
= (modified) duration of liabilities
• Show how duration changes
– When time changes
– When YTM changes

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 Duration and Immunization
• Immunization is a dynamic portfolio managing strategy
that allows to meet a set of liabilities out of proceeds
from a self-financing bond portfolio
• Some firms want to reduce interest rate risk
– e.g. bank and pension fund
• They can buy or sell bonds
– With matching (modified) durations
• Interest rate risks cancel for immunized portfolios when
(modified) bond duration = (modified) liability
duration

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 Portfolio Immunization
• Portfolio managers have assets and liabilities
– Often their values are close to equal
• Can set asset duration equal to liability duration
– This policy minimizes overall interest rate risk
• Method 1: Look for a single bond with target D
• Method 2: Combine long- and short-term bonds
• Compare the modified durations
– use duration if interest rates are same for both sides

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 Example (1)
• Pension fund offers a $10 mln 5-yr 8% GIC
– Liability duration is 5 years
– Invests in 7-yr 10% bonds at YTM 12.92%
– Is the fund immunized now?

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 Duration Changes (Passive Mgmt)
• A bond’s duration changes as each year passes
– Zeros duration falls by one year
– Perpetuity duration (=(1+YTM)/YTM) does not fall
as time passes
– Coupon bond duration falls by less than one year

• A bond’s duration changes as rates change

– For normal (positively convex) bonds
• Duration goes up when rates go down
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 Immunization Rebalancing
• Rebalance when a significant difference in durations
between liabilities and immunization portfolio occurs

– Changes in interest rates

– Payments made by immunization securities
– Liabilities been paid off

• Continuous rebalancing is not feasible: transaction costs.

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 Example (2a): Zeros
• Pension fund has $100m PV obligations after 8 years
– Assume YTM are the same on both sides
– Only 2-year and 10-year zeros are available now
– So invest w% of $100m on 2-year zeros and (1-w%) of
$100m on 10-year zeros
– Set w%=25% such that portfolio has duration=8
– fund is immunized now
• What will happen after 1 year?
– New obligation duration becomes 7
– New portfolio duration is 25%*1+75%*9=7
– No rebalance is required
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 Example (2b): Zeros+ perpetuity
• Pension fund has $100m PV obligations after 8 years
– Assume YTM=10% are the same on both sides
– Only 2-year and perpetuity are available now
– w* 2 years + (1-w)* (1+0.1)/0.1 = 8
– Set w=1/3 such that portfolio has duration=8
– fund is immunized now
• What will happen after 1 year?
– New obligation duration becomes 7
– New portfolio duration is w*1+ (1-w)* 11=7
– w=0.4 and rebalance is required

FINA 3080 Prof. Chao Ying 44

Modified duration: different YTMs
• Pension fund has $20m PV obligations after 5 years
with 10% interest rate.

– Only 2-year and 8-year zeros are available now,

priced at YTM 20%

• How to invest on 2-year and 8-year zeros?

FINA 3080 Prof. Chao Ying 45

 Modified duration: different YTMs
• Pension fund has $20m PV obligations after 5 years
with 10% interest rate.
– Only 2-year and 8-year zeros are available now,
priced at YTM 20%
• How to invest on 2-year and 8-year zeros?

𝐷𝐷𝐿𝐿 𝐷𝐷𝐴𝐴 5∗1.2 60

• = → 𝐷𝐷𝐴𝐴 = = .
1+0.1 1+0.2 1.1 11
28
• 𝑤𝑤 ∗ 2 + 1 − 𝑤𝑤 ∗ 8 = 𝐷𝐷𝐴𝐴 → 𝑤𝑤 =
66
28 28
• $20𝑚𝑚 ∗ 2-year zeros; $20𝑚𝑚 ∗ 1 − 8-year zeros
66 66
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 Lecture 5: Assignments
• Review chapter 10 & 11
• Read chapter 13.1-4
– Practice problems:
• PS: Ch. 13 (1-3, 6, 9-11, 18-20, 23)
• CC: Ch. 13 (1-3, 5)
• Work on Problem Set #1
– Due by 11 am on Oct 11th, 2023 (Wednesday).
– Please submit on BB.
– One group only needs to submit once. Write down group
members’ name & SID.

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